Current Perspectives Summary

Target-Date Funds

Do Target-Date Funds Make Sense for NEST?

The news that NEST, the government-mandated workplace pension scheme, is adopting target-date funds (TDFs) as the default choice for members is likely to meet a mixed response in the industry. Target-date funds have come in for some criticism in certain quarters. Given that possibly millions of workers could soon be relying on these defaults, we wanted to test the validity of these criticisms.

Perhaps the most damaging accusation made against TDFs came after the market meltdown in 2008. That year saw many TDFs in the US suffering significant drops in value by virtue of their high allocation to equities around retirement age.

However, most of the TDFs that did so were “through retirement” plans: those designed so that members could draw an income from their investments for a further 30 years or so. In such cases, a high equity allocation may be sensible if returns have to continue to be generated from a nest egg. As it has turned out, most of those US funds that had poor returns in 2008 have made a full recovery in the succeeding years.

This analysis also helps deal with another criticism of TDFs: that their performance is “end-point sensitive”. Whether this is an issue with NEST depends on how the scheme’s default funds are implemented.

In previous practice, however, TDFs have been managed on the basis that the target date in the fund name is only an indication of when an individual may retire, rather than being a certainty. As a result, the investment design adopted has typically reflected the possible need for the fund to run many years beyond its target date, while also being able to cope robustly with those individuals who may have to draw on their savings earlier than expected.

Then there is a view that TDFs are inflexible because they tend to be run by a single manager. This can be a valid criticism, but not with NEST. It will be truly open architecture, with the winners of the fund management mandates being overseen by a board of independent trustees. We think that will prove quite a flexible structure.

As for costs, we don’t think this is going to be an issue, given that NEST is confident of delivering its default funds for anywhere between 0.3% and 0.5% a year. At that level, it will look very competitive against most of the competition. Indeed, we think NEST will turn into the standard against which the rest of the industry will have to judge itself—and that may be no bad thing.